Question

Suppose that the central bank observes a drop in real GDP. If it believes that GDP dropped because of a decline in total factor productivity. How would the central bank respond? (a) Assume neutrality of money. (b) Redo this question by using the Friedman-Lucas Money Surprise model.

Answer 1

Ans. Neutrality of Money Equation of Money Neutrality is as follows: MⓇV = P x Y where M is the quantity of money, V is the velocity of circulation of money (the average number of times in a given period that a unit of currency changes hands), P is the average price level, and Y is real output. Effectively, it says that over a given period, the amount of money used to purchase all goods and services in an economy, Mx V, is equal to monetary value of this output, PX Y. If the velocity of money is approximately constant-which is an assumption of quantity theory-then spending PⓇ Y is approximately proportional to M. The quantity equation can also be used to explain a consequence of money neutrality. If money neutrality holds, then an increase in the money supply, M, will not affect Y, real output, or the speed with which money changed hands, V, because if real output is unaffected, there would be no need for money to change hands more rapidly. However, it will cause the aggregate price level, P, to rise. Friedman - Lucas Surprise model is also known as new classical macroeconomics-an approach to macroeconomics that seeks the macroeconomic conclusions of individuals maximizing utility on the basis of rational expectations and companies maximizing profits. The assumption is made that all agents are roughly alike, and thus solving the problem of one agent is the same as solving that of millions of similar agents (or the per capita income and consumption of the average agent). The Surprise theory of money did not include money, they were called real business cycle models. According to this model expansions and contractions represent efficient operation of the economy in response to external real shocks. Because the level of economic activity at any time is consistent with maximizing expected utility, the policy recommendation of RBC theory is for government not to intervene in the economy with discretionary fiscal and monetary policy.